Robertson’s 1983 ratio model

1. Introduction

For this blog I will describe a ratio model developed by Robertson in 1983. It is a model that has stood the test of time since the ratios included are those that best measure overall changes in financial health It:

Identifies changes in financial health and allows examination of the individual ratio movements in order that corrective action can be taken. The final model comprised of the following ratios, each of which will be described in Section 3. The ratios are referred to by using R1 to denote ratio 1 through to R5 to denote ratio 5.

R1 = (Revenues – total assets) ÷ revenues

R2 = Profit before taxation ÷ total assets

R3 = (Current assets – total debt) ÷ current liabilities

R4 = (Equity – total borrowings) ÷ total debt

R5 = (Liquid assets – bank borrowings) ÷ trade payables

The financial change model (FCM) takes a similar form to Altman’s 1968 model where the total score is found:

FCM = 0.3R1 + 3R2 + 0.6R3 + 0.3R4 + 0.3R5

The model was developed using a systems approach. This required a statement of ‘key elements’ identifiable in failed companies, followed by the development of ratios which have individual meaning and will help to measure each of the elements; finally the provision for feedback (by observing the movements in the scores obtained from the individual ratios) to allow corrective action to be taken if necessary.

2. Key elements

The identification of the key elements was produced using literature, also from a detailed examination of the data already collected for eight failed companies. The ‘key elements’ identifiable in failed companies were:

Trading instability

Most failing companies experience a fall in sales generated from their asset base. This is true both of the declining product life cycle and the rapid expansion or over-trading company.

Declining profits

The conditions encountered in trading instability can erode a company’s profit margins and when combined with other uncontrolled costs can result in substantial losses.

Declining working capital

If not checked, declining profits can lead to a decline in working capital, accelerating if the company turns into a loss situation. Further reductions in working capital can be caused by continued expansion of net-current assets, especially when financed from short–term borrowings.

Increase in borrowings

Instead of tackling the problem of trading instability and profitability, the failing company increases borrowings to maintain its required level of working capital. This has a double effect in that:

It further reduces profits through additional interest payments;

It increases the gearing of a company at a time when it is most vulnerable.

The selection of ratios to be included was considered to be the most important factor in the development of the model. Each ratio was selected to reflect the elements that cause changes in a company’s financial health. An explanation of each of the ratios is given below.

3. The Ratios finally selected

R1 (Revenues – total assets) ÷ revenues

This is a measure of trading stability. It highlights the important relationship between assets and revenues. When a company increases its asset base, it is looking for a corresponding increase in revenues. Companies experiencing trading difficulties are unable to maintain a given level for this ratio. Deterioration indicates a fall in the revenue generated from the asset base. If this ratio is maintained it can produce a stabilising effect even for a company that has problems with costs and/or borrowings.

R2 Profit before taxation ÷ total assets

Profit is taken after interest expense but before tax, because failing companies borrow more and suffer increases in interest payments in the years leading to failure. Total assets exclude intangibles and are used as the base because they are not influenced by financing policies and tend to remain constant or increase. Failing companies tend to show a decline in profits in the years leading to failure, often turning into a loss. The deterioration in profit is sufficient to cause this ratio to fall. However, many companies are involved in rapid expansion and this, if present, could cause a further decline in the ratio.

R3 (Current assets – total debt) ÷ current liabilities

This is an extension of the net working capital ratio, and requires that long term debt is also deducted from current assets. It measures a company’s ability to repay its current debt without liquidating non-current assets. When compared over a number of years, failing companies show a marked deterioration in this ratio due to the current assets falling while total debt remains constant or even increases.

R4 (Equity – total borrowings) ÷ total debt

This is a gearing ratio. A low ratio indicates a high proportion of debt which means high gearing with associated high risk. Failing companies experience a drop in equity through a combination of losses in operations and reorganisation/extraordinary costs, while at the same time borrowings tend to increase. This can turn a healthy balance in favour of equity into a negative balance where borrowings exceed equity. Should a company not borrow but instead obtain additional funds from shareholders, then this will have a stabilising effect and reduce the risk of moving toward high gearing and associated interest payments. It will also help to reduce borrowings and improve liquidity ratios.

R5 (Liquid assets – bank borrowings) ÷ trade payables

This ratio tests changes in immediate liquidity. After deducting bank borrowings from liquid assets it is then possible to measure the immediate cover for trade payables. Increasing bank borrowings incurs additional financing costs for current and future periods and might require the company to agree to a fixed and/or floating charge over its assets.

4. Weights

The weights used were selected to adjust the natural values obtained from certain ratios. For example, the ratio of profit before tax divided by total assets could only, at best, produce a natural score of 0.20 (equivalent to a 20% return on total assets) while a liquidity ratio or a gearing ratio could easily produce a natural score of 1.00 or more. In this case the weights allow the profit ratio to be increased and/or the liquidity or gearing ratios to be reduced. Weights can also be used to increase the effect of one ratio and/or reduce the effect of another.

Each ratio should contribute equally to the overall score and by a series of simple arithmetic calculations a set of weights applicable to a group of companies (or even a single company) was arrived at. The resulting weights should be easy to use and experiments were carried out by changing the weights (for example doubling and halving a ratio weight). This showed, contrary to expectations, that changes in individual ratio weights did not significantly affect the total score when comparing a company year–on–year.

5. Interpretation of the score

In traditional ratio analysis, the same ratios are used across ‘industries’ with ratio values being interpreted by observing the movements from previous periods or from an industry average. Given that the model was developed for use across ‘industries’, it is appropriate to use similar interpretation, i.e. observing the movements in the total (and individual) scores.

In testing the model it was found that, when the total score fell by approximately 40 percent or more in any year, substantial changes had taken place in the financial health of a company. Immediate steps should be taken to identify the reasons for the change and take remedial action. If the score falls by approximately 40 percent or more for a second year running, the company is unlikely to survive, unless drastic action is taken to stop the decline and restore financial health.

In practice, the model should be used to identify all movements in the total score; further checks should then be carried out on the individual ratios contained in the model in order that action be taken to correct the situation.

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